Diversification - It's Not Just for Investments Anymore

Joseph M. Few
Senior VP, Director of Consulting Services
Retirement Capital Group, Inc. - Southeast

Since childhood we’ve been taught to avoid putting “all our eggs in one basket.” For many years, this simple phrase has been a guiding principle to those who wish to mitigate risk. In particular, those planning for retirement have long been taught the value of diversification. Generally, to diversify has meant to employ the strategy of spreading the risks associated with investing across a broad array of different investments. Spreading investments across a number of investments (equities, fixed-income) and asset types (large cap, small cap, international) makes good, common sense. If any investor wants to achieve attractive returns while reducing risk, diversification is the key.

Today, though, the term diversification has taken on a new meaning. Not only must we consider the need to diversify our investments, but it pays to diversify the tax treatment of those investments as well. We’ve been taught for many years to take advantage of qualified plans (IRAs, 401(k)’s, etc.), a tactic that allows us to save on a pre-tax basis and watch our money grow tax deferred. Dollars received at retirement from qualified plans are then taxed at ordinary income tax rates. If we assume that our tax rate in retirement will be lower than the rate in effect when the income was deferred, the strategy pays off with higher net income. But is it safe to assume that tax rates will be lower at retirement?

As the chart above illustrates, today’s ordinary income and capital gains tax rates are at historic lows. The trend, though, appears to be leading us toward higher tax rates than those we enjoy today. Current congressional leadership seems unanimous in its goal of increasing taxes, particularly the marginal rates paid by those considered “high income.” On October 25, 2007, House Ways and Means committee chairman Charles Rangel introduced the "Tax Reduction and Reform Act of 2007," which seeks to eliminate the Alternative Minimum Tax (AMT) by (1) allowing the Bush tax cuts to expire and (2) adding a surcharge of 4% to the highest tax rates. The net effect: tax rates at the highest bracket would increase from 35% to 44%, an astounding increase that exceeds 25%! Although this bill is unlikely to pass in its current form, it is clear that there is significant momentum in Congress for an increase in tax rates in the future, especially for higher income individuals.

Thus, instead of putting all their retirement “eggs” in the “pre-tax basket,” many are now considering the benefit of diversifying the tax treatment of their retirement savings. This strategy is most effective when dollars are saved in an account that provides retirement income that’s free from tax. This is the Roth strategy, and it is growing in popularity.

The Roth 401(k)

The Roth concept was introduced in 1997 as the Roth IRA. In the Roth IRA, an individual saves for retirement on an after-tax basis. The account grows without taxes and allows for non-taxable withdrawals once the executive has stopped working. The Roth 401(k), introduced in 2006, expanded the Roth concept as an option to employer-sponsored plans. In 2008, individuals can contribute up to $15,500 to their 401(k) plan, which can be spread between their pre-tax and their after-tax Roth accounts. (At age 50, the contribution limit is increased to $20,500.) The hitch is that these limits apply to contributions to both types of 401(k) plans, so participants can't save $15,500 in a regular 401(k) and another $15,500 in a Roth 401(k). Although the introduction of the Roth 401(k) does not increase the amount that can be saved, it does provide an opportunity for tax diversification.

Participants who are offered this new option face a difficult choice: either contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars) or stick with a traditional 401(k) and hope that during retirement their tax rate will be lower than it is now. Alternatively, they could hedge their bet by splitting their contribution between both types of accounts. Making a sound decision hinges on their estimation of the taxes they think they will pay in retirement years.

What impact would rising tax rates have on an investment in a pre-tax account? The chart below demonstrates this effect.

Assumptions:

Age 45 today, retiring at 65
Annual income $100,000, growing at 3% per year
Annual contribution of 15.5%
Tax rates now – 35%
Tax rates at retirement - 45%
Investment return – 7%

For many 401(k) participants, the ability to contribute up to $15,500 into the traditional and/or Roth 401(k) options will be sufficient. For those at higher incomes, however, retirement income replacement goals cannot be met with the 401(k) alone. That is why most companies have introduced some type of nonqualified deferred compensation alternative.

Nonqualified Deferred Compensation

Traditional Nonqualified Deferred Compensation (NQDC) plans have been the solution for those highly-compensated participants who have capped out their contributions to the company's 401(k) plan. From a tax and investment standpoint, NQDC plans operate just like the traditional pre-tax 401(k). For the most part, participants in these nonqualified plans have no limitations placed on their pre-tax deferrals. However, investors using these plans face two major concerns:

Their account balances (money deferred and earnings) are subject to the claims of the company's general creditors. With the new legislation under 409A, plans are less flexible.
They face the same future income tax rate uncertainties described above. Because of the larger amounts deferred, they are very likely to be in the highest income tax bracket at the time of distribution.

These concerns have led a growing number of companies to offer a new option to their nonqualified deferred compensation plan: The Executive Roth Plan^SM.

The Executive Roth Plan^SM

The Executive Roth Plan^SM (ERP) differs from a traditional NQDC plan, just as the Roth 401(k) differs from a traditional 401(k). Just like the Roth 401(k), contributions to the ERP are made on an after-tax basis. Also, just like the Roth 401(k), ERP distributions in retirement are not taxable. During the accumulation years, however, ERP dollars accumulate earnings tax-deferred on the full, pre-tax amount. How does this occur? The unique structure of the ERP gets us there.

The Executive Roth Plan^SM uses an efficiently-priced Variable Universal Life (VUL) insurance contract as its funding vehicle. The VUL has low sales loads, low insurance costs, and no surrender charges. The policy has 100% cash surrender value in Year 1. The VUL also offers access to 60-plus investment alternatives called "subaccounts" from fund managers such as Fidelity, Franklin Templeton, and others.

Additionally, this VUL contract has a unique feature known as the Alternative Loan Rider (ALR), which can restore the taxes that were paid by the participant prior to contribution to the plan. During the contribution phase, after-tax contributions are made to the ERP. Contributions are tax-deductible to the company and trigger a tax liability for the participant each year. In our example we assume a pre-tax income amount of $100,000; after taxes are paid, $60,000 is deposited into the policy. The insurance company rider then adds $40,000 to the premium payment, so the total now equals the pre-tax contribution. Thus, the total premium payment equals $100,000 and the entire amount is allocated among the subaccounts to grow.

At retirement, non-taxable distributions of principal and earnings are made from the policy. At death, the ALR plus capitalized interest is paid from the VUL’s death proceeds, with the remaining death benefit paid to the participant’s beneficiary.

Should My Company Offer the Executive Roth Plan^SM?

There are several options companies can use to offer the ERP to their NQDC participants:

The NQDC can be amended so that all existing account balances are distributed to participants, who then choose to contribute them, plus future deferrals, into the ERP. Under the transition rules of §409A, this amendment must be filed before December 31, 2008 and distributions can begin no earlier than January 1, 2009.
The NQDC can be amended to offer a choice between traditional pre-tax accounts or the after-tax ERP accounts, giving participants the ability to choose. Again, to move existing accounts to the ERP, the elections must be completed by December 31, 2008.
The ERP can be offered as a stand-alone alternative for future contributions only.

Conclusion

With the possibility of higher future tax rates, diversifying the tax treatment of retirement savings can be just as important as diversifying investments. Companies today should explore all the options, including the Roth 401(k) and the Executive Roth Plan^SM. Participants then have the ability to hedge their investments against the debilitating effect of higher future tax rates, and to manage the distribution of their retirement income to maximum effect.

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Securities Offered Through Retirement Capital Group Securities,
a Registered Broker/Dealer, Member FINRA/SIPC
Joseph M. Few, Registered Representative.